Different Measures of Yield and How Changes in Interest Rates Affect Bond Prices - Essay Example

Student number: Name of Lecturer: Subject: There is a need for investors to understand the instruments of money markets. These are the low risk and highly liquid instrument available in money markets worldwide (Ariel, 2007). We explore the bond returns and the risk involve in the bond markets in this paper. They are several definition of bond yield by different scholars but for our discussion we would like to limit our self to Chambers and Carleton (2001). He defines bond yield as the return on investment an investor gets or earns on a bond incase the bond is left in the market until maturity date. It is simply the percentage on the return on investment on bonds and this must be within a specified period of time. In many cases, high yield bonds are usually debt securities in financial markets with lower interest rates but for a longer period of time. The issuing entities of the high yield bond usually do this to raise more capital to expand businesses and also to improve the cash flow in the company (Vasicek, 2003). When the bonds are left to maturity and the expected return on it is realized, then it is said to have realize a yield. And it can be defined as a percentage on the return on investment on the bond (Vasicek, 2003). The general formula for yield calculation is; P = Where CFt = cash flow for the year t P = price of that investment, N = number of years The following are the common yield types found in the market. Yield to maturity This is the total sum amount of return on investment an investor is anticipating at the end of investments period. It is that interest rate which can be used to equate the present value of the invested cash to the cost of the initial investment (Ariel, 2007). The relationship of the bonds is further complicated by the fact that they are being repaid as par value of the investment and this differentiate it with the stock yield of an investment. The yield on the bond reflects both the return on investment and the capital loss or gain on an investment by the end of the investment period. It is calculated by the formula. It is calculated as follows: P = Where P -bond price C- Coupon interest M- Maturity value N- Periods Example Mr. Ken has the debt obligation on bond to be paid as follows; Number of years Cash flow in $ 1 200 2 100 3 150 4 350 If the interest rate is 10% annually, calculate the yield to maturity. = 200/ (1+0.1)1 + 100/ (1+0.1)2 + 150/ (1+0.1)3 + 350/ (1+0.10)4 =182 + 83 +113 +239 = $ 617 Current yield This is normally annual yield income expressed as a total percentage of overall cost of the bond or return on the investment expressed in market price. In current yield, the bond yield is usually calculated based on $ 100 par value. In current yield, the investor finds the percentage rate of return on the invested bond annually. It usually relates to the interest rates of the coupons annually and that of market price. It is calculated as follows; Current yield = interest rate of coupon annually/price of bonds. Unlike the way other scholars argue, (Protte 1990) believe that calculation of current yield considers only one important factor; and that is interest rate of the coupon. Worked example The coupon annual interest rate is 10% and the price of the bonds is $200. Calculate the current yield Solution = 10/200 = 5% Yield to call. The issuer of the bond can decide to call his bond during the first date of call; the yield gotten from such kind of a bond is called a yield to call. The use of call date as the maturity date of the bond in the yield to call is what makes it different from the call to maturity yield. In most cases investors calculate both yield; that is, yield to maturity and yield to call and the lower of the two will actually give the most promising investment return. One most important factor to note when calculating yield to call is that it normally assumes the interest of coupons in any bond as being reinvested at its call to yield rate. Yield to Maturity This is the return that any investor will get if he waits with his bond until the date for call. The price at which the bond is called is usually known us called price (Tavella and Randall, 2000). At this point we assume that the investors will call the bond at a particular date in point so there is need to calculate the call price. Yield to call is given by P = Where M* is the call price and n* is time. Example Consider the following bonds; Maturity date is 10 years; coupon rate is 10%, the par value is $ 2000, and the first call is in the 6 years time. Required Calculate the first call. Solution = = 2000[1/ (1+0.1)6] = $ 1128.95 Absolute Yield Absolute yield is the method through which the yield spreads are calculated in the bond market. The spread of the yield is simply the measure of the difference between the two yields in the market. It is calculated by Yield spread = yield in bond X – Yield in bond Y Example Mr. John is an investor in bond security with two bonds; A and B. The yield in bond A is 15% while that of bond B is 6%. Find the yield spread of the bonds. Solution Yield spread = yield in bond A – yield in bond B = 15% - 6% = 9% Effect of changes in interest rates on the bond prices Before investing in the bonds, it is advisable for any investor to fully understand the bond markets and the various risk involve. Though, the bond market is more secure compared to stock markets, bonds have fixed interest rate of return for a specific period of time. When investing in the bond market, the investor should understand two major risks involved in the market. First is the credit risk. This is to mean that the issuer of the bond will not be in a position to make a regular interest and the principal payment. Secondly is the interest rate risk as the main focus in this discussion. This entails; a) Types of Issuers of the bond In most cases the market is classified according to the people who are issuing out bonds. Australian bonds are issued by the Municipal Governments, Foreign Government or Domestic Corporations. Each and every sector or players issuing bonds are subjected to different risk and rewards in the market. Within the markets, the market is further classified into sectors which give common characteristics like financial sectors, industrial sectors and the interest rates which also expose investors to different risks. b) Inherent Credit Worthiness of Issuer of the bond Circumstances may arise when the issuer of the bond is not in a position to pay the interest and the bond principal in time and this is a risk called credit risk or risk of default of payment. Unstable economic environment in different countries brings with it insecurity money and bond markets which brings inflation within the economy. The interest rates keep on changing either upwards or downwards. These changes in the interest rate are what are called interest rate risk. Research Studies like that of (Vasicek, 2003) has discovered that interest rates are inversely related to the bond price. That is, any increase in the interest rates will automatically lower the bond prices. On the other hand, any decrease in the interest rates will increase the bond prices. To clarify this point, the example below is given; Take a point where you hold a bond worth $10,000 for the next 5 years at an interest rate of 4% and the coupon is paid quarterly. Due to inflation, the interest rate of the bond market increases to 6% after two years. If you want to sell your bond now before then, the person who wants to buy your bond must be willing to forgo the 2% increase in price since the bonds are issued at fixed interest rates for a fixed period of time. But incase the market interest rates of bonds has reduced to 2% then it means the bonds your holding is fetching higher return compared to other bonds in the markets hence it will be regarded as cash cows which will translate to higher prices in the market (Kidwell et al., 2010) Apart from interest factor, time factor also affect the bond prices in relation to interest rates where by long term bonds are more riskier compared to short term ones. This is due to future uncertainty in economic changes therefore investors should not only consider the interest rates but other factors like time of bond maturity as well. References Ariel, Z. (2010), Methods of Pricing Convertible Bonds Dissertation. Milton, Qld: John Wiley & Sons Australia. Chambers, D.R. and W. Carleton, (2001), ”A Generalized Approach to Duration”, Research in Finance, Vol. 7, 2000, 163-181, JAI Press Inc. Kidwell, D.S., Brimble, M., Basu, A., Lenten, L., Thomson, D., Blackwell, D.W., Whidbee, D., & Peterson, R. (2011). Financial markets, Institutions and money (2nd ed.). Milton, Qld: John Wiley & Sons Australia. Protter, P. (1990): Stochastic Interception and Deferential Equations. New York: Springer- Verlag Tavella, D.and Randall, C. (2000), Pricing Financial Instruments: The PDE Method. Wiley Vasicek, D. (2003): “An Equilibrium Characterization of the Term Structure,” J. Financial Ecori., 5, 177- 188 Read More